The firms had bought into a bond deal arranged by Goldman Sachs Group Inc. in 2021 that financed the purchase of dozens of apartment buildings in San Francisco, one of the nation's priciest markets. But by the end of 2022, the companies that borrowed the money had defaulted and the loan backing the securities was eventually sold off at a deep loss.

Then Midland Loan Services Inc, a go-between that intervenes for bondholders when assets struggle, delivered more bad news: Investors weren't going to get $164 million they had coming to them — for at least a little while, as questions surrounding the fate of the deal were worked through. Holdbacks can happen in commercial mortgage bonds, but this one was unusually large, big enough to expose multiple classes rated investment grade by Kroll Bond Rating Agency to possible losses.

The step has drawn attention on Wall Street as a potential new X-factor risk in the $1 trillion market for commercial mortgage-backed securities. The real estate market is already contending with a historic downturn, but some investors now worry that servicers will make surprise decisions that end up significantly hurting their returns in deals.

Stav Gaon, a strategist at Academy Securities Inc., says the holdback in the Midland deal is likely the largest ever seen in that corner of the US securities market, and raises the odds investors will face additional hurdles as other deals lapse into default.

"This is a risk investors did not expect," Gaon said, stressing that there may well be a good explanation for the large amount held back. "There's no reason to think that something like this won't happen again."

More than a month after its attention-grabbing disclosure, Midland, a unit of PNC Financial Services Group Inc., has not offered many details on why it held back the large sum, nor is it obligated to. The main theory is that Midland, fearing bondholders might file a lawsuit, retained the funds in order to pay for unforeseen expenses related to litigation, according to people with knowledge of the situation.  

A Midland spokesperson declined to comment for this story. The company previously said in a statement that "while PNC typically does not comment on specific transactions, we can share that based on the unique attributes of SASB (single asset, single borrower) deals and specific factors related to this portfolio, the size of the holdback is appropriate."

Spokespeople for Angelo Gordon, LibreMax and Goldman Sachs declined to comment. Lord Abbett didn't respond to requests for comment. 

Big loss

The commercial mortgage bond is backed by a loan that two borrowers, Veritas Investments and Baupost Group, took out in 2020 against more than 60 apartment complexes in San Francisco, according to loan documents. Goldman Sachs bundled the loan into commercial mortgage backed securities in 2021. 

In 2022 and 2023, many apartment landlords nationally found themselves bleeding cash. The most aggressive Federal Reserve rate hiking in decades had boosted financing costs for real estate owners, one of the key factors erasing profits even though rents had been rising in many markets.

Amid these headwinds, Veritas and Baupost defaulted on the $675 million loan. Midland was appointed to oversee the increasingly troubled debt in November 2022, according to a Kroll report. Veritas and Baupost declined to comment.

Midland's job — as a special servicer — was to extract maximum value from the loan, through steps such as selling or renegotiating it, and pass the money on to bondholders.

The servicer proposed selling the loan for a minimum price of around $515 million. But Angelo Gordon, LibreMax, and Lord Abbett raised concerns that that price was too low, according to people familiar with the matter and a Kroll report that didn't identify the specific noteholders. 

It is unclear why Midland elected to sell when it did, but market veterans say that, when loans default, it's not always clear whether the best way to recoup value for bondholders is to sell the loans at current market prices, wait for prices to improve, or pursue some other option such as foreclosing on the underlying properties. Such decisions are especially fraught in markets undergoing big changes in valuations, as was the case in last year's multifamily commercial real estate sector.

Despite the objections, Midland ended up selling the loan to Brookfield for net proceeds of around $513 million, triggering a loss of nearly 25% on the original value of the loan. That meant that two classes of bondholders most exposed to the risk — those holding the class G note and some of the class F note — would take losses, according to a note by Gaon. Brookfield declined to comment.

Then, Midland's holdback exposed additional bondholders to potential losses, including those holding the class E, D and some of the C notes, respectively rated BB-, BBB-, and A- by Kroll.

The credit markets have largely defied speculation that the Federal Reserve's interest-hike hikes would cause a surge of defaults as companies were weaned from a long era of easy money. Such concerns flared after the collapse of Silicon Valley Bank and two other banks set off fears of a credit crunch, only to fade after the economy proved surprisingly resilient. Recently, with investors anticipating that the Fed will start cutting rates this year, they've demanded smaller yield premiums on some commercial mortgage-backed bonds, a sign of easing concern.

But distress has been building across the real estate industry. Landlords are offloading office buildings at half off, or even $1, as remote work becomes the norm. More recently, problems are brewing in the multifamily apartment sector. Potential distress in that sector topped $67 billion as of last quarter, surpassing the $55 billion of distress in the office sector, according to an MSCI report.

This looming mountain of distress has made Wall Street especially sensitive to conflicts like the one involving the portfolio of San Francisco apartment debt. If interest rates remain high and more deals get into trouble, then special servicers are likely to find themselves acting as referees on more and more deals.

JPMorgan strategist Chong Sin wrote in a note that in the Midland deal factors including the lack of explanation and the large size of the holdback could contribute to investors growing less confident about the securities. Investors are still determining what incentives servicers may have in resolving deals in the future.

"This reminds investors that they don't have as much control as they think they do," said Liza Crawford, co-head of securitized research at TCW. "It opens the door to a new level of risk that could materially disrupt investors' expected returns."